Government Involvement 1 Price Controls Floors and Ceilings

Government Involvement #1 -Price Controls: Floors and Ceilings #2 -Subsidies #3 -Excise Taxes #4 -Externalities 1

#1 -PRICE CONTROLS Who likes the idea of having a price ceiling on gas so prices will never go over $1 per gallon? 2

Price Ceiling Maximum legal price a seller can charge for a product. Goal: Make affordable by keeping price from reaching Eq. P Gasoline S $5 Does this 4 policy help consumers? 3 Result: BLACK Price MARKETS 2 Ceiling Shortage 1 (Qd>Qs) D To have an effect, a price ceiling must be below equilibrium o 10 20 30 40 50 60 70 80 Q 3

Price Floor Minimum legal price a seller can sell a product. Goal: Keep price high by keeping price from falling to Eq. P Corn S $ Surplus (Qd<Qs) To have an effect, Price Floor a price floor must be Does this above equilibrium 4 3 policy help corn producers? 2 1 o D 10 20 30 40 50 60 70 80 Q 4

Are Price Controls Good or Bad? To be “efficient” a market must maximize consumers and producers surplus P S CS Pc PS D Qe 5

Are Price Controls Good or Bad? To be “efficient” a market must maximize consumers and producers surplus P S Price FLOOR Pc CS DEADWEIGHT LOSS The Lost CS and PS. PS INEFFICIENT! D Qfloor Qe 6

Are Price Controls Good or Bad? To be “efficient” a market must maximize consumers and producers surplus P S CS Pc PS D Qe 7

Are Price Controls Good or Bad? To be “efficient” a market must maximize consumers and producers surplus P S Pc Price CEILING DEADWEIGHT LOSS The Lost CS and PS. CS INEFFICIENT! PS D Qceiling Qe 8

#2 Subsidies The government just gives producers money. The goal is for them to make more of the goods that the government thinks are important. Ex: • Agriculture (to prevent famine) • Pharmaceutical Companies • Environmentally Safe Vehicles • FAFSA 9

Result of Subsidies to Corn Producers Price of Corn S SSubsidy Price Down Quantity Up Everyone Wins, Right? Pe P 1 D o Qe Q 1 Q Quantity of Corn 10

11

#3 Excise Taxes Excise Tax = A per unit tax on producers For every unit made, the producer must pay $ NOT a Lump Sum (one time only)Tax The goal is for them to make less of the goods that the government deems dangerous or unwanted. Ex: • Cigarettes “sin tax” • Alcohol “sin tax” • Tariffs on imported goods • Environmentally Unsafe Products • Etc. 12

Excise Taxes Supply Schedule P Qs $5 140 $4 120 $3 100 Government sets a $2 per unit tax on Cigarettes P S $5 4 3 $2 80 2 $1 60 1 o D 40 60 80 100 120 140 Q 13

Excise Taxes Supply Schedule P Qs $5 $7 140 $4 $6 120 $3 $5 100 Government sets a $2 per unit tax on Cigarettes P S $5 4 3 $2 $4 80 2 $1 $3 60 1 o D 40 60 80 100 120 140 Q 14

Excise Taxes Supply Schedule P Qs $5 $7 140 $4 $6 120 $3 $5 100 STax P S $5 4 Tax is the vertical distance between supply curves 3 $2 $4 80 2 $1 $3 60 1 o D 40 60 80 100 120 140 Q 15

Excise Taxes 1. 2. 3. 4. 5. Identify the following: Price before tax Price consumers P $5 pay after tax Price producers get after tax 4 Total tax revenue for the 3 government before tax 2 Total tax revenue for the 1 government after tax o S S D 40 60 80 100 120 140 Q 16

#4 EXTERNALITIES 17

What are Externalities? • An externality is a third-person side effect. • There are EXTERNAL benefits or external costs to someone other than the original decision maker. Why are Externalities Market Failures? • The free market fails to include external costs or external benefits. • With no government involvement there would be too much of some goods and too little of others. Example: Smoking Cigarettes. • The free market assumes that the cost of smoking is fully paid by people who smoke. • The government recognizes external costs and makes policies to limit smoking. 18

Negative Externalities 19

Negative Externalities (aka: Spillover Costs) Situation that results in a COST for a different person other than the original decision maker. The costs “spillover” to other people or society. Example: Zoram is a chemical company that pollutes the air when it produces its good. • Zoram only looks at its INTERNAL costs. • The firms ignores the social cost of pollution • So, the firm’s marginal cost curve is its supply curve • When you factor in EXTERNAL costs, Zoram is producing too much of its product. • The government recognizes this and limits 20 production.

Video- Whistle Tips 21

Market for Cigarettes The marginal private cost doesn’t include the costs to society. P Supply = Marginal Private Cost D=MSB QFree Market Q 22

Market for Cigarettes What will the MC/Supply look like when EXTERNAL cost are factor in? Supply = P Marginal Social Cost Supply = Marginal Private Cost D=MSB QOptimal QFree Market Q 23

Market for Cigarettes If the market produces QFM why is it a market failure? P S =MSC S=MPC At QFM the MSC is greater than the MSB. Too much is being produced Overallocation D=MSB QOptimal QFree Market Q 24

Market for Cigarettes What should the government do to fix a negative externality? P S =MSC S=MPC Solution: Tax the amount of the externality (Per Unit Tax) D=MSB QOptimal QFree Market Q 25

Market for Cigarettes What should the government do to fix a negative externality? P S =MSC =MPC MSB = MSC S=MPC Solution: Tax the amount of the externality (Per Unit Tax) D=MSB QOptimal QFree Market Q 26

27

Positive Externalities 28

Positive Externalities (aka: Spillover Benefits) Situations that result in a BENEFIT for someone other than the original decision maker. The benefits “spillover” to other people or society. (EX: Flu Vaccines, Education, Home Renovation) Example: A mom decides to get a flu vaccine for her child • Mom only looks at the INTERNAL benefits. • She ignores the social benefits of a healthier society. • So, her private marginal benefit is her demand • When you factor in EXTERNAL benefits the marginal benefit and demand would be greater. • The government recognizes this and subsidizes flu 29 shots.

Market for Flu Shots The marginal private benefit doesn’t include the additional benefits to society. P S = MSC QFree Market D=Marginal Private Benefit Q 30

Market for Flu Shots What will the MB/D look like when EXTERNAL benefits are factor in? P S = MSC D=Marginal Social Benefit QFM QOptimal D=Marginal Private Benefit Q 31

Market for Flu Shots If the market produces QFM why is it a market failure? P S = MSC D=Marginal Social Benefit D=MSB QFM QOptimal Q 32

Market for Flu Shots P At QFM the MSC is less than the MSB. Too little is being produced S = MSC D=Marginal Social Benefit Underallocation QFM QOptimal Q 33

Market for Flu Shots What should the government do to fix a negative externality? P Subsidize the amount of the externality (Per Unit Subsidy) S = MSC D=MSB =MPB D=MPB QFM QOptimal Q 34

Economics of Pollution Why are public bathrooms so gross? The Tragedy of the Commons (AKA: The Common Pool Problem) • Goods that are available to everyone (air, oceans, lakes, public bathrooms) are often polluted since no one has the incentive to keep them clean. • There is no monetary incentive to use them efficiently. • Result is high spillover costs. Example: Over fishing in the ocean 35

Perverse Incentives 1. In 1970, the government tried to protect endangered woodpeckers by requiring land developers to report nests on their land to the EPA. The population of these bird decreased. Why? Land owners would kill the birds or else risk lengthy production delays. (Known as “Shoot, Shovel, and Shut Up”) 2. Assume the government wanted to limit a firm from polluting. They tell them they will inspect them twice and they must reduce pollution by 5%. The amount of pollutants would increase. Why? These firm will have the incentive to pollute more prior to inspection. Are their “market solutions” to these problems? 36

How can markets and self interest help to limit pollution? Government can sell the right to pollute Assume the lake can naturally absorb 500 gallons of pollutants each year 100 The Gov’t sells each firm the right to pollute a set number of gallons 100 Now what does each firm have the incentive to do? 200 50 50